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The average American still feeling the effects of the Great Recession can be forgiven for not being riveted on the fact that state and local governments across the country are facing another fiscal crisis in the form of a public pension “tsunami” of epic proportions. Fixing the problem will require fundamental changes to public retirement plans.

According to Standard & Poor’s, 32 states are confronting budget shortfalls in fiscal 2015 and/or 2016. One contributor to those ills is growing unfunded public pension liabilities that now range as high as $4.7 trillion nationwide according to a report from State Budget Solutions, a non-profit organization that advocates for state budget reform. The unfunded liability works out to about $15,000 per person.

Public employees have been promised more than state and local governments can ever afford to pay and taxpayers are on the hook for the shortfalls. Many retirement plans are not setting aside enough money to make good on their promises to current and retired state employees. Some, such as Detroit and Stockton, Calif., have already declared bankruptcy; countless public pension systems are in dire shape.

Moody’s dropped Chicago’s bond rating to junk status after the Illinois Supreme Court overturned state pension reforms. That means the Chicago taxpayers will be paying higher interest rates on the money the city borrows.

Last week the New Jersey Supreme Court ruled that the state did not have to increase its contribution to ensure the solvency of its ailing pension system. Politicians there found that shifting liabilities into the future by underfunding pensions was a convenient way to deliver on promises of low taxes and richer retirement benefits.

In Massachusetts, unfunded state and local pension and retiree health care liabilities total around $75 billion.

Most state and local governments in the United States offer defined-benefit pension plans to which both employees and employers contribute. The plans are supposed to provide public employees with guaranteed income, creating a financial liability for taxpayers when workers retire. Under this type of plan employees accrue the right to an annual benefit usually determined as a percentage of a worker’s average salary over the final years of employment multiplied by the worker’s years of service.

Under this arrangement, the employer is responsible for determining how much to set aside for employees’ retirement fund and how to invest it. Government (taxpayers) assumes the risk of coming up with the extra money if there is a shortfall. Government has several basic options in that case: they can raise taxes, make budget cuts, or default on their obligations. Given the magnitude of pension liabilities, some states may seek a federal bailout as was done for Wall Street and the automakers.

In contrast, the defined contribution plans that now prevail in the private and not-for-profit sectors empower employees to save for their own retirement and manage their own investments. A defined contribution plan transfers investment risk from the employer to the employee.

These are the simplest, most transparent, portable and straightforward pension plans. The employee and employer both contribute, the employee decides where to invest the funds and bears responsibility for investment risk. Upon retirement, there is often an opportunity to cash out with a lump sum payment or to select an annuity whereby payments are made to the retiree over a specified period.

However bad the problems are now, the pension situation is likely to get worse as politicians continue to “kick the can down the road,” the cliche that describes politicians’ response to virtually every fiscal crisis. One thing that would help would be to replace current defined benefit plans with a defined contribution plan for new public employees as Georgia, Michigan, Utah, and Oklahoma have done.

Such a move would minimize the risk of one major but often forgotten stakeholder: taxpayer.

originally published: June 20, 2015

The economic crash that began in 2008 is a triple whammy for ordinary Americans: their jobs, homes and retirement incomes are all at risk.

Too little money has been set aside to keep the promises made by both private- and public-sector pension plans. As a result, the American dream of a golden retirement is fading fast.

Standard & Poor’s estimates that the funding shortfall for corporate pensions and related benefits was $578 billion in 2011.

As bad as that sounds, state and local governments’ problems are even worse. According to the National State Budget Crisis Task Force, public pensions are underfunded by $1 trillion to $3 trillion.

Employers typically offer defined-benefit or defined-contribution pensions. Corporations have gradually closed their defined-benefit plans and replaced them with defined-contribution plans such as 401(k)s, though many still owe money to retirees who were part of the old defined-benefit systems. Most local governments continue to offer defined-benefit plans.

Defined-benefit plans provide post-retirement benefits that are typically a percentage of average salary during an employee’s last few working years. The employer promises to pay a fixed retirement benefit regardless of how the plan’s investment portfolio performs.

When private pension funds cannot meet their obligations, the federal Pension Benefit Guaranty Corp. steps in. This agency guarantees the pensions of about 44 million participants in about 27,000 corporate defined-benefit plans .

The Pension Benefit Guaranty Corp., which is primarily funded by investment income and insurance premiums collected from corporations, pays beneficiaries up to $54,000 annually when a company cannot meet its pension obligations. But the cost of rescuing failed corporate plans has saddled the corporation with a $26 billion deficit.

So who backstops the Pension Benefit Guaranty Corp.? Maybe it is time for the agency to set the insurance premium the way other private insurers and the Federal Deposit Insurance Corp. do. This would avoid a repeat of Fannie Mae.

There is no equivalent of the Pension Benefit Guarantee Corp. for state and local government defined benefit plans, which are ultimately backed by taxpayers.

One cause of unfunded pensions is the Great Recession. Pension funds invest in a portfolio of assets whose returns are expected to pay the lion’s share of the plan’s obligations.

The funds commonly assume they will earn 8 percent. With compounding, it is a handsome return. But in this environment, the chances of doing that are between slim and none without shifting portfolio composition toward higher-yielding but riskier assets.

The political class in Washington, D.C., has been less than honest in dealing with the retirement time bomb. Part of the two-year transportation funding bill that was finally signed last month updates the Pension Protection Act of 2006 by increasing the premiums the company sponsors of pension plans must pay to the Pension Benefit Guarantee Corp.

The law allows pension plan sponsors to ignore current interest rates when calculating their obligations and pretend rates are closer to their 25-year average. That means plan sponsors can make smaller pension contributions over the next I0 years.

This will exacerbate the funding crisis, but provide government with a short-term tax windfall. Since firms get a tax deduction for contributions to their pension funds, they pay more taxes if they put less money into them.

As a result, the provision is supposed to generate $9.5 billion for the Highway Trust Fund. The ploy fills the shortfall between current federal fuel tax revenue and projected transportation spending without raising the 18.4-cent federal fuel tax, which has not increased since 1993.

If the pension plan blows up, the Pension Benefit Guarantee Corp. will be the ones to pick up the shortfall. And that, of course, means you.

originally published: August 18, 2012